The honeymoon period is well-known in personal relationships. At the beginning, we present a perfect version of ourselves, and see our new partner for the flawless person they must be. We don’t like to consider how this relationship might go wrong and how we might protect ourselves when needed.
Commercial landlord and tenant relationships may be less romantic but they are not immune from initial rose-tinted glasses. Landlords can feel optimistic, excited by a business’s snazzy new product or innovative technology (or the opportunity to offload a void unit). Potential tenants don their best suit, impressing the landlord with tales of booming business once the location is operational.
But landlords have an advantage over loved-up couples: unlike romantic candidates (except the best ones), all but the newest companies have evidence of their financial attractiveness. While profits and losses and balance sheets can’t tell the full story, they’re often the basis for testing a potential tenant’s appeal, by comparing principal rent with recent net profits and assets.
Where the potential tenant fails the tests, or the landlord otherwise doubts its “good tenant” prospects, the landlord may agree to let only if security is provided. But what form of security?
Rent deposits
Arguably the most popular choice, a rent deposit is a simple concept: tenant deposits money with landlord; landlord draws on money to satisfy debts.
Rent deposits are extremely flexible in a number of respects. For example:
Quantum
Generally the deposit level is tied to principal rent, with three to six months’ worth being usual, but deposits as low as one month’s rent and as high as 12 months’ rent are fairly common.
Structure
Most commonly, the money remains the tenant’s property, but is placed in a separate deposit account in the landlord’s name and charged to the landlord. Trusts are also popular, where the money becomes landlord property, held on trust for the tenant.
Repayment
Most deposits subsist until the lease ends or is assigned, but sometimes landlords agree to repay when financial tests are satisfied.
A well-drafted rent deposit deed protects the tenant; for example, by ringfencing the money from landlord funds in case of future landlord insolvency. And, due to the deposit’s finite nature, the tenant’s exposure is limited (although this doesn’t limit overall liability).
However, thanks to their flexibility, RDDs are not as straightforward to negotiate as landlords may hope. For example:
Withdrawals
Rent deposits should secure tenant covenants under the lease and ancillary documents. But sometimes landlords insist on the ability to withdraw for losses which they would not, but for the deposit, be entitled to recoup. Often these relate to void periods following lease expiry, such as “rent in lieu” until the property is relet, and reletting costs.
Top-ups
RDDs invariably require the tenant to top-up the deposit to a minimum level (eg six months’ rent) in the event of withdrawal, rent review or VAT rate adjustments. But often they don’t require the landlord to tell the tenant the sum required. The tenant won’t have visibility of the account and therefore of interest accrual levels, so it may want to delay the top-up obligation until the landlord has specified the amount needed. This could be administratively burdensome for landlords.
Interest
Landlords usually agree that interest accruing on the deposit belongs to the tenant; by default, interest remains in the deposit account and is released to the tenant when repayment is triggered (after permitted deductions). But where expected interest sums are substantial, a tenant might want interest to be released periodically, often annually but sometimes even quarterly.
Charges
RDDs typically include a tenant’s warranty that the money will not become subject to any third-party charge. Landlords are reluctant to argue over priority status with competing creditors should the tenant become insolvent. But such warranties overlook the most likely charge to which the money might become subject: an all-assets floating charge. Floating charges would rank behind the fixed charge to the landlord (if not already crystallised), so the tenant may seek to carve them out to avoid a technical but harmless breach.
Another drawback of rent deposits for tenants is VAT treatment. Where VAT is payable on the rents, the landlord will require the deposit to include a sum “equivalent to VAT” on the principal deposit, so it can withdraw for the principal liability and VAT on it. However, a deposit is not paid in consideration of a VAT supply, so the “VAT” cannot be reclaimed until the landlord withdraws for a VAT-able liability. As this increases cash flow implications for the tenant, it may seek to reduce the deposit level once tax implications are understood.
Parent/director guarantees
Where the tenant has a financially stronger parent/group company, the landlord may prefer a guarantee of the tenant’s obligations from that company instead of a rent deposit.
The primary advantage to the landlord is that the guarantor’s liability is (generally) unlimited, and (generally) extends to the guarantor undertaking to perform the tenant’s covenants – not simply indemnifying the landlord for breaches – and taking a new lease itself if the tenant’s lease is forfeited or subject to disclaimer. A secondary benefit is the lack of administrative burden.
The primary advantage to the tenant is that a corporate guarantee does not reduce its cash balance at lease completion.
Another benefit is lower negotiating costs and time. While guarantee provisions are often subject to some negotiation, the back-and-forth is typically less than with an RDD because the market has a largely settled idea of what guarantee provisions should say. On a lease assignment, there is often zero negotiation because many leases dictate future guarantees’ terms.
Why aren’t guarantees more common?
Availability
Not every company has a group member with sufficient covenant strength.
Willingness
The landlord’s primary upside is the potential guarantor’s primary downside – their liability is usually unlimited, so they may be unwilling to act as guarantor.
Insolvency
While the guarantor may be stronger than the tenant, no company is bulletproof. So while insolvency may be less likely, it must still be considered as a possibility.
Enforceability
Landlords may be concerned about the ability to enforce the guarantee given the ease with which guarantees can be inadvertently released and given guarantors’ propensity to fight enforcement. Concerns are compounded where the guarantor is overseas-incorporated; plus, if the landlord accepts an overseas guarantor, it will usually require a legal opinion from home jurisdiction lawyers, thus undoing some of the cost and time savings of a guarantee over a rent deposit.
Overall, landlords often feel that a bird in the hand (a rent deposit) is worth two in the bush (a guarantee).
Much of the above also applies to director guarantees, with the added complication that such guarantees require the directors to put their personal assets at risk. For this reason, and due to issues in proving the directors’ financial worthiness, director guarantees are rare.
Bank guarantees
Most landlords would be happy to accept a guarantee from a financially sturdy bank. Since the bank usually has recourse to the tenant if enforced, bank guarantees act as a risk transfer from landlord to bank. Enforceability tends to be less of a concern, and a bank guarantee is not affected by the tenant’s (or its group’s) insolvency.
Nevertheless, they are rare. Because the bank must pay out even if the tenant becomes insolvent, many banks are only willing to provide guarantees where:
- liability is capped, which the landlord may not accept; and/or
- the tenant places a large deposit with the bank to underpin its indemnity, which the tenant may not accept.
Bank guarantees usually involve large upfront tenant costs, plus ongoing fees.
Bank guarantees can cause similar cost and capital tie up issues as rent deposits, and tenants usually prefer the latter. But sometimes the tenant won’t be given that choice, and the landlord may insist on a bank guarantee for tenants who are unable or unwilling to provide a suitable corporate guarantee or suitably sized rent deposit.
Final thoughts
Each security option has benefits and drawbacks and there is no one-size-fits-all solution; what the tenant is prepared to offer and what the landlord is willing to accept depends on a variety of factors. There is rarely an option which both parties consider to be perfect but imperfect security is better than none – think how many transactions wouldn’t happen without it.
Giorgia Mayes is a managing associate at Penningtons Manches Cooper LLP
